1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation.  On June 30, 2015 (the “Effective Date”), Masco Corporation (“Masco” or the “Former Parent”) completed the separation (the “Separation”) of its Installation and Other Services businesses (the “Services Business”) from its other businesses.  On the Effective Date, TopBuild Corp. (“TopBuild” or the “Company”), a Delaware corporation formed in anticipation of the Separation, became an independent public company which holds, through its subsidiaries, the assets and liabilities associated with the Services Business.  The Separation was achieved through the distribution of 100 percent of the outstanding capital stock of TopBuild to holders of Masco Corporation common stock.  Immediately following the Separation, Masco Corporation stockholders owned 100 percent of the outstanding shares of common stock of TopBuild.  References to “TopBuild,” the “Company,” “we,” “our,” and “us” refer to TopBuild Corp. and its consolidated subsidiaries.

 

Prior to the Separation, the consolidated financial statements of TopBuild were prepared on a stand-alone basis and reflect the historical results of operations, financial position, and cash flows of Masco’s Services Business, including an allocable portion of corporate costs.

 

We report our business in two segments, Installation and Distribution.  Our Installation segment principally includes the sales and installation of insulation and other building products.  Our Distribution segment principally includes the distribution of insulation and other building products.  Our segments are based on our operating units, for which financial information is regularly evaluated by our corporate operating executives.

 

Financial Statement Presentation.  The consolidated financial statements have been developed in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”).  Historically, stand-alone financial statements were not prepared for the Services Business.  Separation related adjustments recorded in the Consolidated Statements of Changes in Equity primarily relate to a cash distribution of $200 million made by TopBuild to Masco immediately prior to the Separation, offset by net transfers from the Former Parent.

 

All intercompany transactions between the TopBuild entities have been eliminated.  Transactions between TopBuild and Masco prior to the Separation, with the exception of purchase transactions, are reflected in equity in the Consolidated Balance Sheets as “Former Parent investment” and in the Consolidated Statements of Cash Flows as a financing activity in “Net transfer from (to) Former Parent.”

 

The accompanying consolidated financial statements for the periods prior to the Separation include allocations of general corporate expenses that were incurred by Masco for functions such as corporate human resources, finance, and legal, including salaries, benefits, and other related costs.  These general corporate expenses were allocated to TopBuild on the basis of sales.  Total allocated general corporate costs were $13.6 million, $21.9 million, and $22.1 million for the years ended December 31, 2015, 2014, and 2013, respectively and are included in selling, general, and administrative expense.

 

Prior to the Separation, Masco incurred certain operating expenses on behalf of the Services Business which were allocated to TopBuild based on direct benefit or usage.  These allocated operating expenses were $5.6 million, $17.8 million, and $16.0 million for the years ended December 31, 2015, 2014, and 2013, respectively and are included in selling, general, and administrative expense.  An estimate of these operating expenses were allocated to each of TopBuild’s reporting segment, based on a percentage of sales.

 

For the periods prior to the Separation, these consolidated financial statements may not reflect the actual expenses that would have been incurred had we operated as a stand-alone company and may not reflect the consolidated results of operations, financial position, and cash flows had we operated as a stand-alone company.  Actual costs that would have been incurred had we operated as a stand-alone company prior to the Separation would depend on multiple factors including organizational structure and strategic decisions made in various areas, including information technology and infrastructure.

 

During the first quarter ended March 31, 2015, we identified an error related primarily to the misallocation of a favorable legal settlement to general corporate expenses of TopBuild in the fourth quarter of 2014.  The impact of the error was to understate the allocation of corporate expense reported as selling, general, and administrative expense and overstate operating profit by $1.9 million.  The error was not considered material to the previously reported 2014 financial statements.  We recorded the correction of the error by an out-of-period adjustment in the first quarter of 2015 which is therefore reflected in the twelve months ended December 31, 2015 Consolidated Statements of Operations and Consolidated Statements of Cash Flows.

 

Use of Estimates and Assumptions in the Preparation of Financial Statements.  The preparation of our consolidated financial statements in conformity with U.S. GAAP requires us to make certain estimates and assumptions that affect the reported amounts of assets and liabilities, and disclosure of any contingent assets and liabilities, at the date of the financial statements, and the reported amounts of sales and expenses during the reporting period.  Actual results may differ from these estimates and assumptions.

 

Revenue Recognition. We recognize revenue for our Installation segment using the percentage of completion method of accounting based on the amount of material installed and associated labor costs at our customers’ locations compared to the total expected cost for the contract.  The amount of revenue recognized for our Installation segment, which had not been billed as of December 31, 2015 and 2014, was $23.7 million and $23.6 million, respectively.  Revenue from our distribution segment is recognized when title to products and risk of loss transfers to our customers.  At time of sale we record estimated reductions to revenue for customer programs and incentive offerings, including special pricing and other volume‑based incentives. 

 

Income Taxes.  We account for income taxes using the asset and liability method, which requires recognition of deferred tax assets and liabilities for expected future tax consequences of temporary differences that currently exist between tax basis and financial reporting basis of our assets and liabilities.  Deferred tax assets and liabilities are measured using enacted tax rates in the respective jurisdictions in which we operate.

 

Valuation allowances are established against deferred tax assets when it is more likely than not that the realization of those deferred tax assets will not occur.  In evaluating our ability to recover our deferred tax assets within the jurisdiction from which they arise, we consider all available positive and negative evidence.  If, based upon all available evidence, both positive and negative, it is more likely than not (more than 50 percent likely) such deferred tax assets will not be realized, a valuation allowance is recorded.  Significant weight is given to positive and negative evidence that is objectively verifiable.  A company’s three year cumulative loss position is significant negative evidence in considering whether deferred tax assets are realizable and the accounting guidance restricts the amount of reliance we can place on projected taxable income to support the recovery of the deferred tax assets.

 

Interest and penalties on our uncertain tax positions, if recorded, are reported in income tax expense.

 

Cash and Cash Equivalents.  We consider our highly liquid investments with a maturity of three months or less at the time of purchase to be cash and cash equivalents.

 

Receivables, net.  We do business with a significant number of customers, principally homebuilders.  We monitor our exposure for credit losses on our customer receivable balances and the credit worthiness of our customers on an on‑going basis and record related allowances for doubtful accounts.  Allowances are estimated based upon specific customer balances where a risk of default has been identified, and also include a provision for non‑customer specific defaults based upon historical collection, return, and write‑off activity.  During downturns in our markets, declines in the financial condition and creditworthiness of customers impact the credit risk of the receivables involved and we have incurred additional bad debt expense related to customer defaults.  Receivables, net are presented net of certain allowances, including allowances for doubtful accounts.

 

Inventories, net.  Inventories, net consist primarily of insulation, rain gutters, garage doors, fireplaces, fireproofing and firestopping products, roofing and shingles, shower enclosures, closet shelving, accessories, and other products.  We value inventory at the lower of cost or market, where cost is determined by the first in‑first out cost method.  Inventory value is evaluated at each balance sheet date to ensure that it is carried at the lower of cost or market.  Inventory provisions are recorded to reduce inventory to the lower of cost or market value for obsolete or slow moving inventory based on assumptions about future demand and marketability of products, the impact of new product introductions, inventory levels and turns, product spoilage, and specific identification of items such as product discontinuance, engineering/material changes, or regulatory-related changes.  As of December 31, 2015 and 2014, all inventory consisted of finished goods.

 

Property and Equipment, net.  Property and equipment, net, including significant betterments to existing facilities, are recorded at cost.  Upon retirement or disposal, the cost and accumulated depreciation are removed from the accounts and any gain or loss is included in the Consolidated Statements of Operations.  Maintenance and repair costs are charged against earnings as incurred.  Gains and losses on the disposal of equipment are included in selling, general, and administrative expense.

 

We review our property and equipment as an event occurs or circumstances change that would more likely than not reduce the fair value of the property and equipment below the carrying amount.  If the carrying amount is not recoverable from its undiscounted cash flows, we would recognize an impairment loss for the difference between the carrying amount and the current fair value.  Further, we evaluate the remaining useful lives of property and equipment at each reporting period to determine whether events and circumstances warrant a revision to the remaining depreciation periods.

 

Depreciation.  Depreciation expense is computed principally using the straight‑line method over the estimated useful lives of the assets.  Estimated useful lives are as follows:

 

 

Fair Value.  The fair value measurement standard defines fair value as the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date (referred to as an “exit price”).  A fair value hierarchy is established that prioritizes the inputs to valuation techniques used to measure fair value.  The hierarchy gives the highest priority to unadjusted quoted market prices in active markets for identical assets and liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements).  The three levels of the fair value hierarchy are:  

 

Level 1: Quoted prices in active markets for identical assets or liabilities.

 

Level 2: Observable inputs other than Level 1 prices, such as quoted market prices for similar assets or liabilities or other inputs that are observable or can be corroborated by market data.

 

Level 3: Unobservable inputs in which there is little or no market data, which require the reporting entity to develop its own assumptions.

 

Goodwill and Other Intangible Assets.  We perform our annual impairment testing of goodwill in the fourth quarter of each year, or as events occur or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount.  We have defined our reporting units and completed the impairment testing of goodwill at the operating segment level.  Our operating segments are reporting units that engage in business activities for which discrete financial information, including long-range forecasts, are available.  We compare the fair value of the reporting units to the carrying value of the reporting units for goodwill impairment testing.  Fair value for our reporting units is determined using a discounted cash flow method, which includes significant unobservable inputs (Level 3 inputs).

 

Determining market values using a discounted cash flow method requires us to make significant estimates and assumptions, including long‑term projections of cash flows, market conditions, and appropriate discount rates.  Our judgments are based upon historical experience, current market trends, consultations with external valuation specialists and other information.  In estimating future cash flows, we rely on internally generated long-range forecasts for sales and operating profits, including capital expenditures, and generally utilize a one to three percent long‑term assumed annual growth rate of cash flows for periods after the long-range forecast.  An impairment loss is recognized to the extent that a reporting unit’s recorded goodwill exceeds the implied fair value of goodwill.

 

Intangible assets with finite useful lives are amortized using the straight‑line method over their estimated useful lives.  We evaluate the remaining useful lives of amortizable intangible assets at each reporting period to determine whether events and circumstances warrant a revision to the remaining periods of amortization.  For additional information, see Note 4 - Goodwill and Other Intangible Assets.

 

Insurance Reserves.  We use a combination of high deductible insurance and matching deductible insurance for a number of risks including, but not limited to, workers’ compensation, general, vehicle, and property liabilities.  Our workers’ compensation insurance is primarily a high‑deductible insurance program and our primary general liability insurance is a matching deductible program.  We are insured for covered claims above the deductibles and retentions.  The liabilities represent our best estimate of our costs, using generally accepted actuarial reserving methods, of the ultimate obligations for reported claims plus those incurred but not reported claims through December 31, 2015 and 2014.  The accruals are adjusted as new information develops or circumstances change that would affect the estimated liability.  We also have an insurance receivable for claims that exceeded the stop loss limit included in other assets on our Consolidated Balance Sheets which offsets an equal liability included within the reserve amount recorded in other liabilities on our Consolidated Balance Sheet.  At December 31, 2015 and 2014, the amount of this receivable and liability was $1.8 million and $1.4 million, respectively

 

Advertising.  Advertising costs are expensed as incurred.  Advertising expense, net of manufacturers support, was approximately $1.5 million, $2.5 million, and $3.1 million for the years ended December 31, 2015, 2014, and 2013, respectively, and is included in selling, general, and administrative expense.

 

Share‑based Compensation.  Our share-based compensation program consists of restricted stock and stock option awards.  We grant restricted stock awards with a fair value based on our closing stock price on the date of grant.  Restricted stock awards generally vest ratably over five years.  We also grant stock options for a fixed number of shares to certain employees with an exercise price equal to the market price of our common stock on the date of grant.  Stock options generally become exercisable (vest ratably) over five years beginning on the first anniversary from the date of grant and expire no later than 10 years after the grant date.  The fair value of stock option awards is determined using the Black-Scholes Options Pricing Model.  We have elected to use the straight-line method to recognize compensation expense evenly over the respective service period for restricted stock awards and stock option grants.  Share-based compensation expense is reported in selling, general, and administrative expense.

 

Debt Issuance Costs.  Debt issuance costs are amortized as interest expense over the life of the respective debt, which approximates the effective interest rate method.

 

Leases.  Leases where the lessor retains substantially all the risks and benefits of ownership of the asset are classified as operating leases.  Operating lease payments are recognized as an expense in the Consolidated Statements of Operations on a straight-line basis over the lease term, including future option periods the Company reasonably expects to exercise, whereby an equal amount of rent expense is attributed to each period during the term of the lease, regardless of when actual payments are made.  This generally results in rent expense in excess of cash payments during the early years of a lease and rent expense less than cash payments in later years.  The difference between rent expense recognized and actual rental payments is recorded as deferred rent and included in other liabilities.  Lease termination costs are accrued over the life of the lease based on historical experience. Leasehold improvements are amortized over the lesser of the expected lease term, including cancelable option periods, or the estimated useful lives of the related assets using the straight-line method.

 

Recently Issued Accounting Pronouncements:  In May 2014, the Financial Accounting Standards Board (“FASB”) issued a new standard for revenue recognition, Accounting Standards Codification 606 (“ASC 606”).  The purpose of ASC 606 is to provide a single, comprehensive revenue recognition model for all contracts with customers to improve comparability across industries.  ASC 606 is effective for us for annual periods beginning January 1, 2018.  We are currently evaluating the impact the adoption of this new standard will have on our results of operations.

 

In April 2014, the FASB issued Accounting Standards Update 2014-8 (“ASU 2014-8”), “Reporting of Discontinued Operations and Disclosure of Disposals of Components of an Entity,” which changes the criteria for determining which disposals can be presented as discontinued operations and modifies the related disclosure requirements.  On January 1, 2015, we adopted ASU 2014-8.  Adoption of the new standard did not have an impact on our financial position or results of operations.

 

In April 2015, the FASB issued Accounting Standards Update 2015-03 (“ASU 2015-03”), “Interest – Imputation of Interest (Subtopic 835-30) – Simplifying the Presentation of Debt Issuance Costs,” which requires that all costs incurred to issue debt be presented in the balance sheet as a direct deduction from the carrying value of the debt.  ASU 2015-3 is effective for us in the first quarter of 2016, however, we elected to early adopt this standard retrospectively during the fourth quarter of 2015.  The adoption of this standard did not affect our Consolidated Statements of Operations.  As we did not incur any debt issuance costs prior to the Separation there is no change to our Consolidated Balance Sheet as of December 31, 2014.

 

In July 2015, the FASB issued Accounting Standards Update 2015-11 (“ASU 2015-11”), “Simplifying the Measurement of Inventory.”  Under the amendment, ASU 2015-11, inventory should be measured at the lower of cost and net realizable value.  Net realizable value is the estimated selling price in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation.  This guidance is effective for fiscal years beginning after December 15, 2016.  Early adoption is permitted.  We do not expect the adoption of this amendment to have a material impact on our financial position or results of operations.

 

In November 2015, the FASB issued Accounting Standards Update 2015-17 (“ASU 2015-17”), “Balance Sheet Classification of Deferred Taxes.”  This guidance requires that all deferred tax assets and liabilities, along with any related valuation allowance, be classified as noncurrent on the balance sheet.  ASU 2015-17 is effective for us in the first quarter of 2017, however, we early adopted this new standard prospectively during the fourth quarter of 2015.  As we adopted this guidance prospectively, prior periods were not retrospectively adjusted.  The adoption of this standard did not affect our Consolidated Statements of Operations.